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“Give me a lever and somewhere to stand,” boasted Archimedes, “and I will move the world”. Give bankers too much leverage (and somewhere to hide), financial regulators appear to have concluded, and they may very well blow the whole thing up.

Hence the leverage ratio. This stipulates that a bank’s assets – regardless of how risky they are perceived to be – must be backed up by a strict minimum amount of equity. Advocates of the measure say it is the simplest way to rein in the wilder tendencies of the banks. But if they think that the leverage ratio can’t be gamed, they should think again.

Basel III requires that by 2019 all banks should have a leverage ratio – technically defined as the proportion of a lender’s Tier 1 equity to its total assets – of at least 3%. Last summer, the UK’s Prudential Regulation Authority put pressure on its charges to clear this hurdle a bit earlier, prompting Barclays into a £4 billion rights issue.

Now there appears to be a growing consensus that the Bank of England might go further than the Basel rules require and ask banks to hike their leverage ratio to 4%, perhaps as early as next year. One senior financial institutions group banker based in London says that all the chief executives he talks to believe that the ratio will be “four or more” before the end of Mark Carney’s first term as Governor of the Bank of England.

Carney’s predecessor Mervyn King foreshadowed this last year at an appearance at the Parliamentary Commission on Banking Standards before he left the job, saying that in the long term even 4% could be too low and he could see it going as high as 10%. The Bank’s Financial Policy Committee is conducting a review into the leverage ratio, as requested by the Chancellor of the Exchequer George Osborne.

The Bank of England declined to comment for this article.
The Swiss regulator has already set the leverage ratio for its banks at 4% and there is continual speculation that it will go higher. And this month, federal regulators in the US hiked the rate for their biggest banks to 5%.

Is that too high? It’s always worth bearing in mind what these abstract numbers mean. At current leverage levels, UK banks borrow 97p of every £1 that they risk in lending. And, even at the new higher level, US banks need lose only five cents of every dollar that they lend before they go bankrupt.

But is the leverage ratio, as Barclays boss Antony Jenkins has claimed, a blunt tool? Yes. Does it, as Deutsche Bank’s co-chief executive Anshu Jain has said, “fail to tell us what we need to know”? Well, that depends on what you ask of it. Does it fail to differentiate between risky and safe assets? Certainly. But that is, to some extent, the point: the leverage ratio has been conceived as a concrete ceiling to limit the activities of the banks.

Sheila Blair, the former chairwoman of the Federal Deposit Insurance Corporation, recently pointed out that many financial regulations are about controlling behaviour, “but there is only so much behaviour you can control”.

In other words, there are plenty of other rules governing what goes on below the leverage ceiling. But at a certain point, blunt is exactly what is called for: the leverage ratio is a regulatory Maginot Line – ils ne passeront pas!

Gaming the system

But, just like the real Maginot Line, the leverage ratio is far from being a perfect defence.
It has become increasingly popular because regulators are concerned that banks, which use their own models to risk-weight the assets against which they hold capital, are gaming the system.

The inference here is that banks can’t optimise their leverage ratio. That is simply not true. The capital regime in the US in the run-up to the crisis was defined by the leverage ratio. And because riskiness is to all intents and purposes irrelevant in this scenario, the banks were incentivised to pile into dodgier assets (like sub-prime mortgages) in the pursuit of outsized returns. That didn’t turn out so well.

Casting our gaze back across the Atlantic, European banks are much more leveraged than their US rivals. The Europeans will rightly point out that this is because they have different business models and own a higher proportion of low-risk government bonds. When they are allowed to risk-weight these assets, the difference between their leverage and that of the US banks doesn’t look so bad.

But a report by Berenberg Bank at the beginning of the year suggested that European lenders might also be stoking the leverage in their investment banking arms by subsidising them with capital from other parts of the group. Again, the leverage ratio would not help to police this kind of behaviour.

More fundamentally, the leverage ratio can only be calculated based on the value that a bank ascribes to its assets. It would be naïve in the extreme to assume that those values are inviolable. As Matt Levine, the Bloomberg columnist, wrote, banks are a pure creature of accounting. And the size of a bank’s assets will depend on how you choose to measure them.

Indeed, under the US’s accounting regime – the Generally Accepted Accounting Principles, used by banks to value their balance sheets – certain assets have a specialised risk weighting. Levine picks out a few examples: lending commitments are risk-weighted at 10% of the loan; equity derivatives with a maturity of over five years are risk weighted at 8%.

Are those risk weightings correct? You tell me.

All of which is to say, leverage ratios are no panacea. In many ways they are just as subjective as the more complex risk-weighted approach that appears to be falling out of favour. The key here is Goodhart’s law – named after the economist Professor Charles Goodhart – which suggests that as soon you adopt a means to measure financial assets it becomes useless as a means of measurement.

In other words, if regulators rely on the leverage ratio too much, they’ll regret it.